Managing Interest Rate Risk

Question 1

Forward rate agreement (FRA)

Answer 1

-> is an agreement between a bank and a customer (company, government or charity) obligated to deliver a specified amount of interest at a specified future date (within a year) at a specified price over the counter
1. The buyer of the FRA obtains the right to lock in an interest rate for a desired term at a future date
2. The contract specifies that the seller of the FRA will pay the buyer the increased interest expense on the debt principle if interest rates rise above the agreed rate
3. The buyer will pay the seller the differential interest expense if interest falls below the agreed rate

Question 2

Interest rate futures contract

Answer 2

-> is an agreement between two parties obligated to deliver a specified amount of interest at a specified date (3 months) and a specified price through an exchange.
1. Terms amount and periods are standard
2. Can be short and long futures contracts
3. If you think interest rates will rise you short futures contract (debt prices fall)
4. If you think interest rates will fall you long futures contract (debt price increases)

Question 3

Interest rate options contract

Answer 3

-> is an agreement between two parties with the right to exchange a specified amount of interest at a specified future date at specified prices through an exchange
1. Interest rate guarantee
2. Has rate cap = sets interest rate upper limit
3. Has rate floor = sets interest rate lower limit

Question 4

Interest rate swap

Answer 4

-> is an agreement between two parties obligated to swap a specified amount of interest at a specified future date at a specified interest price over the counter
1. Two parties may have various motivations for entering into the agreement. One believes interest rates will increase and one believes interest rates will decrease
2. The borrower may conclude that interest rates are about to rise. In order to protect the firm against rising debt service payments, they may enter into a swap agreement to pay fixed/receive floating interest rate swap
3. Similarly, a firm with fixed rate debt that expects interest rates to fall can change fixed rate debt to a floating rate debt. In this case the firm would enter a pay floating/receiving fixed interest rate swap